We reformulate the Smets-Wouters (2007) framework by embedding
the theory of unemployment proposed in Galí (2011a,b). We
estimate the resulting model using postwar U.S. data, while treating
the unemployment rate as an additional observable variable. Our approach
overcomes the lack of identification of wage markup and labor
supply shocks highlighted by Chari, Kehoe and McGrattan (2008) in
their criticism of New Keynesian models, and allows us to estimate a
"correct" measure of the output gap. In addition, the estimated model
can be used to analyze the sources of unemployment fluctuations.